Central bank distortion

Ben Bennett, head of Credit Strategy – Active Fixed Income at Legal & General Investment Management discusses the impact of central banks adding corporate bonds to the monetary menu.

After many years of extraordinary monetary policy, an enormous quantity of government debt now sits on central bank balance sheets. But the recent decision of central banks to buy corporate bonds takes policy to another level – directly setting the cost of debt for companies.

In March of this year, the European Central Bank (ECB) announced it would add corporate bonds to its asset purchase programme. Then in August, the Bank of England (BoE) also announced its intention to buy corporate bonds. The amount involved is up to £10bn for an initial period of 18 months, or a rate of about £130m a week.

Adding corporate bonds to the monetary menu could make sense if capital markets were broken, trading at high yields and unable to determine a fair cost for borrowers and investors. But corporate bond yields are currently at historically low levels, and sound companies have no difficulty raising money. Instead, an intervention could have a detrimental impact, as true investors recoil from yields that do not adequately compensate for risk.

We do not believe such financial repression creates an environment that encourages risk taking, business investment decisions and, ultimately, economic growth – in fact, we suspect quite the reverse.

Future market implications

It seems likely that the euro and sterling credit markets will remain distorted by central bank purchases for some time to come. Investors may take comfort from this support in the short term, particularly if broader credit markets suffer a difficult period. However, this must be weighed up against fundamental value.

Even before central banks started to buy corporate bonds, we did not think credit spreads were cheap versus the risks associated with the asset class. Now, central bank buying is likely to keep valuations further away from fair value. This is important because even though a bond is eligible for the programme, if it is downgraded to sub-investment grade or ultimately defaults, investors could still be faced with steep losses.

How will investors react?

We believe investors will look to switch to less distorted corporate bonds. There are bonds within the euro and sterling investment grade indices that are ineligible for the programmes and that provide a spread pick-up versus eligible bonds. But there are other credit markets, notably the US dollar corporate bond market, which offer an even greater opportunity.

At the margin, we’d also expect to see investors move down the risk spectrum into sub-investment grade in order to pick up extra yield. However, it is crucial to be adequately compensated for the additional credit risk, particularly in less liquid asset classes.

From an issuer perspective, we have already seen companies react to tighter euro and sterling credit spreads by issuing new bonds that they might have otherwise issued in other markets. So far, this has been beneficial for investors who have been able to buy new bonds while credit rallies. But once spreads reach levels that investors baulk at from a fundamental perspective, the situation could become more difficult.

What next for central banks?

Central banks face a dilemma. Their purchases are currently supporting credit valuations, but this may be more than offset by investors leaving the asset class in search of better returns. The ECB and the BoE could then face the unpalatable prospect of allowing the euro and sterling credit markets to underperform other markets until such flows cease, or having to step up their purchases of corporate bonds. We think central banks could end up being sucked in ever deeper, with credit valuations increasingly influenced by their purchases rather than fundamental risk.

In Japan, distortionary policies from the Bank of Japan (BoJ) have forced government bond yields deep into negative territory. But investors are understandably reluctant to purchase corporate bonds with a negative yield, so credit spreads have actually widened as a result. Issuance has been slow because companies do not want to pay this extra risk premium and the BoJ is now under pressure to step in to drive corporate bond yields into negative territory. The situation is in danger of becoming absurd.

Unfortunately, it seems monetary madness is here to stay for the foreseeable future.